James Faulkner on Molins: a smoking opportunity?

There are certainly more interesting companies out there than Molins, which makes machinery for the tobacco industry. But this is certainly not a business that is about to go up in smoke. In fact, Molins might just be about to light up. The US Government is tightening regulations for tobacco smoke – and Molins just so happens to produce the instruments that do the testing, too.  

With a two-thirds market share, Molins is well positioned to harvest this upside. The investment case is topped off by strong tangible asset backing and an undemanding valuation. The recent strength of sterling is taking its toll, but this may provide an attractive entry point for new investors.

Reassuringly old…

Molins (MLIN) is reassuringly old. With its beginnings as a cigar and cigarette maker in Havana in the late 19th century, it moved to London at the turn of the century to make packaging for various products such as tea and tobacco – in the process being credited for inventing the hinge-lid cigarette package that was so instrumental in the success of the Marlboro brand. These days, the group continues to be involved in supplying machinery, related support services and systems, principally to the consumer goods sectors, including tobacco, food and other high volume products. Its exposure to areas of the economy which have very low price elasticity of demand makes it a rather defensive play – some would say boring, but therein lies the opportunity.

Molins is organised into three separate divisions: Packaging Machinery, Tobacco Machinery and Scientific Services. The first two divisions represent the cash-generating core of the business and together account for around three quarters of total sales; the latter meanwhile represents a nascent growth opportunity for Molins, and it is this division that I wish to talk about here.

The Scientific Services division comprises Arista Laboratories, based in Richmond, Virginia, an independent tobacco and cigarette smoke constituent testing laboratory for regulatory, research and product development purposes; and Cerulean, the market-leading supplier of quality control instruments and analytical smoke constituent capture machinery to the tobacco industry, as well as other instruments and machinery to other industrial sectors. Cerulean is based in Milton Keynes, with sales and service offices in a number of key locations that support the needs of its global customer base. With a 50-60% market share Cerulean is the world number 1, and stands to benefit greatly from a more rigorous tobacco testing regime in the US.

Tobacco/smoke testing: a potential $100 million market…

In March 2012, the US Food and Drug Administration (FDA) instructed all US tobacco companies to test their cigarettes against 20 harmful compounds, which significantly increased the regulatory burden for the industry. While 4 of the top 5 manufacturers have decided to conduct this analysis in-house, many of the smaller cigarette makers lack the economies of scale to do so and have instead opted to outsource the work to third party specialists, such as Molins’ Arista Laboratories. However, there could be much, much more to play for.

In the coming months, the FDA is widely anticipated to decide to extend the testing regime from the current 20 compounds to include more constituents from the entire list of 93 harmful (and potentially harmful) chemicals covered in the legislation. Significantly for Molins, this could force the larger manufacturers to out-source part of their testing requirements. Although this opportunity is currently at a very early stage, research house Equity Development reckons the US market could alone be worth c.$100 million per annum within five years. Where the US leads, the rest of the world usually follows suit, so it is not unreasonable to assume that other jurisdictions would subsequently implement similar measures and further extend the market opportunity for Molins.

Recent trading…

Although investors will no doubt be anxious for an update on the FDA’s new tobacco testing regime – which was due last December but failed to materialise – Molins recently posted a strong set of results in February which highlight the resilience of the business. The diversity of the firm’s operations, all of which occupy strong positions in niche markets, offer a good level of protection from downside in any one of the group’s individual markets – as evidenced by the weakness in Arista having been offset by strength in Cerulean, for example. We are also optimistic regarding the firm’s pipeline of new products, including an e-cigarette instrument and enzyme sampler from Cerulean, and several new cigarette and filter makers from Tobacco Machinery, which should help drive growth. There is also the potential for targeted acquisitions which could put the firm’s cash reserves to good use.

Valuation…

I believe that Molins shares remain undervalued by several valuation methods. At the current 162.5p, the shares trade on 8 times house broker Panmure Gordon’s earnings estimate for the current year, falling to just 7.2 times for FY15. This is roughly half the engineering sector average, even before taking into account the firm’s significant cash resources. Clearly this represents some level of disappointment regarding the lack of news regarding the FDA’s tobacco testing regime, but we believe this to be overdone given that it is simply a matter of time before this is announced. With £5.2 million of net cash and £40.5 million of net assets as at 31st December the balance sheet is strong.

There is also risk surrounding the pension deficit, but we note that the recent improvement (from £13.9 million to £2.5 million) is likely to continue as bond yields ‘normalise’. Aside from the pension scheme, we see the main risks to Molins to be currency risk (only 10% of sales are in the UK) and potential ongoing delays to new tobacco testing regulations in the US. Overall, being a highly internationally diversified business with strong cashflow characteristics and market-leading positions in various industries, we believe Molins remains good value.